Farr: Has The Fed Lost Control Of The Bond Markets?

In mid October, 2007, the Dow Jones Industrail Average traded at an all-time high of about 14,200. In the weeks and months that followed, it moved progressively lower. By January 2008, it had fallen 1,000 points and by March 2,000 points. As prices fell in October and November 2007, do you think anyone thought, "Maybe this is it. Maybe this is the beginning of a major correction."? We doubt that they did, and if they did, we're pretty certain that they didn't call for a drop below 7,000. What do the beginnings of big drops look like and feel like?

Bond investors should be asking themselves these questions.

For quite some time now, we have been writing about the loftiness in the Treasury bond market. We have repeatedly said that high-quality stocks appear attractive when considering the meager yields available through investment in Treasuries.

Well, it seems that the euphoria over bonds may be over…for now. The recent sell-off in bondshas left the yield on the 10-year Treasury at a six-month high, while the S&P 500trades at very close to a two-year high.

The sell-off in bonds has been fast and furious, especially over the past week.

This development is no doubt a major headache for the Fed, whose major policy goal has been to keep rates low in an effort to 1) stabilize the housing market; 2) stimulate borrowing, spending and investment; and 3) force investors into riskier assets such as stocks in an effort to create wealth, drive consumer spending, and stimulate job creation.

So the recent developments in the bond markets raise the question: has the Fed lost control of the bond market? It certainly appears that way right now.

Ironically, it seems that the Fed has finally gotten what it wanted. It has finally convinced Congress and the administration that the economic recovery is extremely tenuous and in need of additional stimulus. However, in a perverse twist of fate, the prospect of additional fiscal stimulus seems to be offsetting the benefits of the Fed's monetary stimulus. The announcement of tax cut extensions and payroll tax holidays has led to sharply higher interest rates - precisely what the Fed does not want.

Let's examine all the possible explanations for the sell-off in bonds over the past couple of months. For our part, we can point to may inter-related causes:

Recent weakness in the dollar, in part as a result of the QE2 announcement, has led to a sharp rally in commodity prices. Investors are worried about the more widespread and longer-term inflationary implications of flooding the economy with dollars.

Recent economic data suggest the economy may be recovering (albeit slowly) on its own, and that additional quantitative easing may be unnecessary in light of the longer-term risks of inflation.

The proposed tax cutextensions and new payroll tax cuts have bond investors worried about the implications on budget deficits over the next few years. The higher the deficits climb, the more the government must borrow. Is there a limit to the demand for US Treasury debt?

The new tax cut proposalssuggest to some that the Fed may not need to fulfill its stated QE2 goal of buying an additional $600 billion in Treasuries. In addition, the new fiscal stimulus measures take the prospect of QE3 off the table (for now). If the Fed is likely to buy less bonds, this removes a lot of demand from the market.

The Deficit Commissionwas unable to muster the 14 votes necessary to force Congress to vote on its proposals. While this was expected, investors are becoming increasingly pessimistic about Congress' ability to address the long-term structural deficits caused by entitled programs (Social Security, Medicare).

Some investors may be unwinding their "flight-to-quality" trades in the absence of more bad news this week out of Europe. While this may be a short-lived correction, we believe it may be factoring into the Treasury selling in recent days.

So it seems that there are indeed numerous reasons for the sell-off in bonds. The real surprise to us is why the sell-off did not come sooner.

We suspect that the problems in Europe led many investors to the safety of Treasuries, which kept a strong bid for the bonds in an otherwise weakening market. Having said that, we think there may be a limit to how high bond yields came climb in the near term. We simply do not believe the weak economy can support sharply higher interest rates just yet. According to the Wall Street Journal, mortgage rates averaged 4.66% last week - up sharply from a low of 4.21% in October. Mortgage rates are undoubtedly higher again this week. Given the huge amount of foreclosures, unsold inventories, and underwater mortgages, higher mortgage rates are likely to exacerbate the weakness in an already troubled housing market. And as faithful readers of our market commentary know, we believe housing is one of the key elements to a sustainable economic recovery.

Longer-term, we continue to believe that high-quality stocks offer strong relative value compared to bonds. Continued obstacles to a sustainable economic recovery are likely to lead to continued volatility in the bond markets. In fact, we would not be surprised to see rates head down again as the economic challenges become more fully appreciated. However, long-term investors are likely to fare better in stocks given the historically low yields available in the bond market.

The staggering size of the US Debt along with the size of the deficit render the option of "growing our way out" as impossible. Some portion of our debt will have to be monetized. While the near-term concern continues to be deflation, inflation and much higher interest rates are inevitable. It will be quite painful to be caught on the wrong side of this trade.

This post was written by Michael K. Farr and Keith B. Davis, CFA. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.